A government-mandated accounting rule that was intended to keep large institutions from overstating their holdings is emerging at the center of the recent credit meltdown. Whether the practice known as mark-to-market accounting helped cause the crisis, or simply alerted investors to impending trouble, is a hotly debated issue.
Adopted in the wake of corporate finance scandals earlier this decade, Rule 157 of the U.S. Financial Accounting Standards Board’s regulations (FASB 157) requires commercial banks to value securities and loans held on their balance sheets quarterly according to prices being paid for similar instruments on the market, whether or not the bank planned to sell those assets. FASB 157 took effect with fiscal years that began after Nov. 15, 2007.
Today in testimony before Congress, former American International Group chief executive Martin Sullivan said the accounting practice created tens of billions of dollars in paper losses for the insurance firm. Those unrealized losses contributed to the insurer’s rapid decline that ultimately required an $85 billion bailout by the U.S. Treasury last month.
What happened? Marking to market isn’t designed to work in a transactional vacuum, and the market for mortgage-backed securities has disappeared in a world grown averse to mortgage risk. The volume of U.S. commercial mortgage-backed securities (CMBS) issued in July through September this year was zero, compared with nearly $60 billion issued in the same period of 2007.
Marking to market at a time when there is no demand for a security can produce punitive pricing because the few bonds that do trade are likely to be underperforming or sold by distressed sellers — or both. Basing the value of securities on a handful of fire-sale transactions tends to result in undervaluing a bank’s balance sheet.
Sullivan is far from alone in lambasting the rule. “Without mark-to-market fair value accounting, this crisis would never have reached this level,” Chicago billionaire Sam Zell told real estate executives on Sept. 23. Speaking at a conference hosted by DLA Piper in Chicago, Zell said marking to market fueled a whirlpool of declining valuations that self-perpetuated by creating ever lower marks.
Urged on by industry leaders and associations including the Commercial Mortgage Securities Association, lawmakers gave the Securities and Exchange Commission authority to suspend FASB 157 as part of the new bailout measure for the banking industry. At press time for this report, the SEC hadn’t yet acted on the provision, but observers are optimistic that mark-to-market accounting will be placed on hold, at least until the markets stabilize enough to support greater transaction volume.
A change in accounting practices should improve the effectiveness of the bailout in helping banks regain some liquidity, says Beth Lambert-Saul, director at Archon Group LP, a wholly owned subsidiary of Goldman Sachs in Dallas. “Mark to market is one of the things that was just killing people,” she says. “And every time you write down your investment, it’s a self-fulfilling prophesy.”
Yet the alternative — valuing securities to a model or to a standard that doesn’t reflect current sales — creates its own problems by skewing values upward. That’s why policy makers likely couldn’t have avoided the current crisis simply by suspending mark-to-market accounting sooner, according to Dan Smith, managing director of the Dallas-based real estate mortgage capital division of RBC Capital Markets. “The issue would have been that you would have had massive balance sheets that in effect would have been overstated.”
Economists agree that the credit crisis is too complicated to be fixed by merely suspending an accounting rule. FASB 157 is “something that people want to seize on but it’s not a central part of the problem,” says economist Jim Smith. “The central part of the problem is way too much leverage in the system, and unwinding that leverage is not going to be pretty,” says Smith, who is Professor of the Practice at the Institute for the Economy and the Future at Western Carolina University.
Greater transparency into the assets on bank balance sheets is essential to reduce the fear of further calamity that is throttling the credit markets, according to Edward Leamer, professor of management, economics and statistics at the UCLA Anderson School of Management.
“Suspension of mark-to-market rules has appeal but it also has problems,” Leamer says. “The appeal is that you don’t want banks to go insolvent as a consequence of the fear driving market valuation. But fear is partly created by a lack of trust and transparency.”
Both Leamer and Jim Smith say a lack of confidence in banks is a more pressing aspect of the credit crisis than FASB 157. Leamer believes the key to restoring liquidity is to increase transparency, perhaps by requiring banks to disclose all of the assets on their balance sheets, forcing those institutions to realize their losses and move on. “Delaying the loss is what freezes up the economy,” he says.
Kenneth Rudy, president and chief operating officer of capital markets at full-service real estate firm Jones Lang LaSalle, agrees that FASB 157 is a small part of a bigger issue. He does believe a temporary suspension of the accounting practice will enable banks to resume lending, however, and then gradually realize losses on bad investments as they dispose of those securities and loans. Rudy describes mark-to-market accounting as “a bad idea in a market crisis, and an idea that tends to exacerbate the market crisis.”
Banks will begin to extend credit again once the government starts buying up the securities that are clogging lenders’ balance sheets, says Smith of RBC Capital Markets. And when that happens, a temporary suspension of mark-to-market accounting will allow those lenders to make more money for the securities they sell, giving them more funds to loan.
Once the credit markets regain their mobility, however, a return to mark-to-market accounting will be an important part of maintaining transparency, according to Smith. “When the market is very liquid and there are a lot of buyers and a lot of sellers, mark to market is a very good thing,” he says. “You want to make sure that the securities you hold are valued correctly.”